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What is Capital Budgeting?
What is Capital Budgeting? – Capital budgeting is the process of examining current or prospective projects to determine whether an investment would be profitable. Companies use capital budgeting for current projects in various ways. For example, a company may be considering replacing a machine. In this instance, the firm will analyze the cash flows and costs in two ways. The first way would be based on the old machine. The firm would determine the production rate of the machine an identified the profits from the old machine. Next, the company would subtract the current cost based on not replace the machine. The second step would be to analyze the project based on the new machine. Here, the firm would do the same steps as above and determined the new revenues and new cost as compared to the old machine. From this analysis, the company would determine whether the firm should replace the machine.
Capital budgeting may also be applied to new projects. With new projects, the firm would estimate future revenues from their proposed project. Next, opportunity cost and other related costs would be deducted from the revenues. This would lead to the net cost for each period. The final step would be to discount each cash flow back to present-day dollars to determine whether the project would be profitable for the firm.
Evaluating Capital Budgeting Decisions
Finance professionals use numerous methods when evaluating capital budgeting decisions. Popular methods include NPV, IRR, profitability index, and the payback method. The gold standard when evaluating capital budgeting decisions is that NPV method.
What is NPV (Net present value)?
What is NPV? - NPV stands for net present value. To calculate the NPV, the cash flows for each period are calculated. Next, cost are subtracted from the cash flows leaving the net income from the project. The third step would be to add back in to the cash flow non-cash cost such as amortization and appreciation. Once this is complete, a discount rate should be identified and each cash flow should be discounted back to present-day dollars. Once this is done, the present values for each cash flow should be added together which would lead to the present value of the project. The final step is to subtract the initial investment from the present value calculated. This will lead to the dollar value the company will grow or shrink if this project is implemented.
What is IRR (Internal rate of return)?
What is IRR? - The IRR or internal rate of return is the interest rate a project will return when the net present value is zero. This process is favored by management because of the simplicity of the process. Managers will calculate the IRR and compare this figure with the firm’s cost of capital. If the IRR exceeds the cost of capital then manager should accept the project. However, if the IRR is lower than the cost of capital, the project should be rejected. When calculating the IRR, most professionals use Excel.
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